Public Finances – Progress Report

By Don Alexander
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The latest IMF World Economic Outlook (WEO) indicates that global growth momentum is slowing while downside risks are increasing.  However, considerable progress has been made over the last two years in strengthening the fiscal accounts following their sharp deterioration over the last few years.  However, the pace of debt reduction is slower than after previous recessions reflecting severity of the recession and sluggish recovery (characteristic of balance sheet recession).

The IMF noted in its latest Fiscal Monitor (October 2012) the emergence of several trends: (1.) Most countries have made significant headway in rolling back fiscal deficits with the greatest progress in advanced economies, where the fiscal shock was largest. (2.) However, the efforts at controlling debt stocks are taking longer to yield results. Debt ratios are not expected to stabilize before 2014–15 in some countries and longer elsewhere. The slow progress reflects a sluggish recovery, high interest rates and fragile nature of the financial system. (3.) Countries with sizable fiscal consolidation needs have relied on a mix of revenue and expenditure policies.  These measures have the smallest negative impact on growth, but those with large fiscal adjustment plans—need to include investment cuts and tax increases that impact growth. (4.)  Spending and revenue measures have implications for employment and social equity, have to be considered if the large consolidation efforts are to be sustainable. However, structural reforms remain the key to better growth and employment prospects.

The Fiscal Monitor noted that the United States and Japan need to act quickly to reduce fiscal policy uncertainty. The United States has to define a clear path to avoid the 2013 “fiscal cliff”—a very sharp increase in taxes and reductions in discretionary spending—and to raise the federal debt ceiling. Japan needs to implement a decisive debt reduction plan that includes reforms to revenues and entitlements.

In Europe, a number of peripheral countries have little choice but to press ahead with planned deficit reductions. In other countries that have more room to maneuver, policymakers should allow automatic stabilizers to operate—for example, through higher unemployment compensation and social assistance—tolerating a higher deficit if growth should slow.  Long-term, Europe must move toward a fiscal union with unified supervision of the banking system.  Elsewhere, a number of emerging countries must take action to reduce their dependence on revenue exposure from a single source.  In other countries, there is a need to moderate ambitious investment plans to match revenues.  This may include the need to reduce subsidies.

Despite progress in restoring the sustainability of public finances, fiscal vulnerabilities remain elevated. Public debt rollover requirements are high and expose countries to the vagaries of financial markets.  Central banks have provided ample liquidity in support of economic activity; markets have taken large increases in public debt in stride, with solvency concerns largely in euro area countries. But these benign market responses are premised on continued fiscal adjustment and a favorable growth environment.

With global risks rising, policymakers must tread the narrow path that will permit them to strengthen the public finances while supporting a fragile recovery.  Adjustment should proceed at a pace that is consistent with the state of the economy.  If growth falters, the first line of defense should be monetary policy and automatic fiscal stabilizers and countries with room for maneuver should slow their pace of planned adjustment. But short-term caution should not delay efforts to put public finances on a sounder footing, as this remains a key requirement for growth. Countries with relatively comfortable fiscal positions should maintain appropriate buffers to be able to confront future shocks.

www.imf.org/external/mmedia/view.aspx?vid=1887258731001

Public Finances – Progress Report

By Don Alexander
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The latest IMF World Economic Outlook (WEO) indicates that global growth momentum is slowing while downside risks are increasing.  However, considerable progress has been made over the last two years in strengthening the fiscal accounts following their sharp deterioration over the last few years.  However, the pace of debt reduction is slower than after previous recessions reflecting severity of the recession and sluggish recovery (characteristic of balance sheet recession).

The IMF noted in its latest Fiscal Monitor (October 2012) the emergence of several trends: (1.) Most countries have made significant headway in rolling back fiscal deficits with the greatest progress in advanced economies, where the fiscal shock was largest. (2.) However, the efforts at controlling debt stocks are taking longer to yield results. Debt ratios are not expected to stabilize before 2014–15 in some countries and longer elsewhere. The slow progress reflects a sluggish recovery, high interest rates and fragile nature of the financial system. (3.) Countries with sizable fiscal consolidation needs have relied on a mix of revenue and expenditure policies.  These measures have the smallest negative impact on growth, but those with large fiscal adjustment plans—need to include investment cuts and tax increases that impact growth. (4.)  Spending and revenue measures have implications for employment and social equity, have to be considered if the large consolidation efforts are to be sustainable. However, structural reforms remain the key to better growth and employment prospects.

The Fiscal Monitor noted that the United States and Japan need to act quickly to reduce fiscal policy uncertainty. The United States has to define a clear path to avoid the 2013 “fiscal cliff”—a very sharp increase in taxes and reductions in discretionary spending—and to raise the federal debt ceiling. Japan needs to implement a decisive debt reduction plan that includes reforms to revenues and entitlements.

In Europe, a number of peripheral countries have little choice but to press ahead with planned deficit reductions. In other countries that have more room to maneuver, policymakers should allow automatic stabilizers to operate—for example, through higher unemployment compensation and social assistance—tolerating a higher deficit if growth should slow.  Long-term, Europe must move toward a fiscal union with unified supervision of the banking system.  Elsewhere, a number of emerging countries must take action to reduce their dependence on revenue exposure from a single source.  In other countries, there is a need to moderate ambitious investment plans to match revenues.  This may include the need to reduce subsidies.

Despite progress in restoring the sustainability of public finances, fiscal vulnerabilities remain elevated. Public debt rollover requirements are high and expose countries to the vagaries of financial markets.  Central banks have provided ample liquidity in support of economic activity; markets have taken large increases in public debt in stride, with solvency concerns largely in euro area countries. But these benign market responses are premised on continued fiscal adjustment and a favorable growth environment.

With global risks rising, policymakers must tread the narrow path that will permit them to strengthen the public finances while supporting a fragile recovery.  Adjustment should proceed at a pace that is consistent with the state of the economy.  If growth falters, the first line of defense should be monetary policy and automatic fiscal stabilizers and countries with room for maneuver should slow their pace of planned adjustment. But short-term caution should not delay efforts to put public finances on a sounder footing, as this remains a key requirement for growth. Countries with relatively comfortable fiscal positions should maintain appropriate buffers to be able to confront future shocks.

www.imf.org/external/mmedia/view.aspx?vid=1887258731001

Increasing Risks & Financial Instability

by Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The latest IMF Global Financial Stability Report (GSFR). From October 2012, notes that, despite favorable financial market developments, risks to global financial stability have increased and markets remain volatile as European policymakers struggle with the crisis. The financial system continues to remain fragile.

Faltering confidence has led to capital flight from countries on the ‘periphery’ to the core of the euro area. This means higher borrowing costs and a growing wedge between the economic and financial ‘haves’ and ‘have-nots’.   Efforts by European policymakers have allayed some fears, but the euro area crisis remains the principal source of concern. Tail-risk perceptions surrounding currency redenomination have fueled a retrenchment of private financial exposures to the euro area periphery. The resulting capital flight and market fragmentation undermine the very foundations of the union: integrated markets and an effective common monetary policy.

The European Central Bank’s (ECB’s) liquidity operations in 2012 helped ease pressure on banks to shed assets, but that pressure rose again, accompanied by increasing market fragmentation. Subsequently, the ECB initiated new steps with government bond buying and these actions have provided temporary market stability, but additional measures are needed. Otherwise, the result is an acceleration in deleveraging, increasing the risk of a credit crunch and an ensuing economic recession. 

In addition, European authorities must continue with three efforts: (1.) reduction of government debts and deficits in a way that supports growth; (2.) implementation of structural reforms to reduce external imbalances and promote growth; and (3.) clean-up of the banking sector, including recapitalizing or restructuring viable banks and resolving nonviable ones.  All this has to be done while supporting growth. More fundamentally, concrete progress toward a banking union in the euro area will help break the link between sovereigns and domestic banks. Over the longer term, a successful banking union will require sufficient pooling of resources to provide a credible fiscal backstop to the bank resolution authority, and joint deposit insurance fund.

The risks to financial stability are not confined to the euro area. Both Japan and the United States face significant fiscal challenges, which, if unaddressed, can have negative financial stability implications.  Both countries require medium-term deficit reduction plans that protect growth and reassure financial markets.

Elsewhere, emerging economies have adeptly navigated through global shocks, but need to guard against potential shockwaves from the euro area crisis, while managing slowing growth in their own economies and are vulnerable as a result of their high direct exposure to euro area banks.  At the same time, several economies in Asia and Latin America are also prone to risks associated with being in the later stages in a credit cycle increasing potential contagion.

The crisis has spurred a host of regulatory reforms to make the financial system safer. This includes: financial institutions and markets that are more transparent, less complex, and less leveraged.  The analysis suggests that, although there has been some progress over the past five years, financial systems have not come much closer to those desirable features. They are still overly complex, with strong domestic interbank linkages, and concentrated, with the too-important-to-fail issues unresolved.

Other areas that still require attention: (1) a global discussion of the pros and cons of direct restrictions on business activities to address the too-important-to-fail issue, (2) more attention to segments of the nonbank system that may be posing systemic risks, and (3) further progress on recovery and resolution plans for large institutions, especially those that operate across borders.  A couple of conclusions that have emerge are that (1) financial buffers made up of high-quality capital and truly liquid assets generally help economic performance; and (2) banks’ global interconnectivity needs to be managed well so as to reap the benefits of cross-border activities, while limiting adverse spillovers during a crisis.  Financial stability will only emerge with effective implementation and strong supervision.

The key lesson is that imbalances need to be addressed well before markets start signaling credit concerns. If there is no credible medium-term plan, markets will force an adjustment over a compressed period, with adverse effects on growth and financial stability.

www.imf.org/External/Pubs/FT/GFSR/2012/02/index.htm